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October 6, l OAc

Memorandum for The President,

Too much emphasis is being put on interest rates.
The real problem is to keep fands flowing freely
and effectively to sustain healthy progress in the economy.
Whether interest rates move a bit higher--or a
bit low er--is not of cardinal importance to the economy.
What is important is whether rates are allowed to t
respond to market forces so that an effective flow of funds is
The trouble confronting us is that rate ceilings-governed by policy determinations--are proving obstacles to the
flow of funds in accordance with natural forces.
And the most immediate obstacle is the ceiling
not on the rate that banks may charge borrowers but on the rate
they may pay depositors to attract funds that the banks need in
order to expand their loans.

Specifically, this is the way matters stand:
- - In vigorous competition to attract funds
to meet increasing loan demands» banks
have been offering higher and higher
rates for certificates of deposit.

-2- - But under ceilings imposed by the Federal
Re serve ls Regulation. Q, going back to
November in 1964, banks are forbidden to
pay more than 4-1/2 per cent to obtain
deposit funds*
- - Some of the leading financial-center banks
are paying the top rate already, and cannot
now go any higher to attract further funds.
- - Banks with lesser standing, especially those
outside the chief financial centers, are being
hard-pressed even to hold present deposits,
much less to gain added deposits, since the
ceiling puts them at a competitive dis­
advantage with financial-center banks of
higher credit standing.
- - These impediments are being reflected in
the credit distribution process in a way that
is distinctly adverse to smaller borrowers.
This obstacle to the attraction of funds for lending
could be overcome by lifting the 4-1/2 per cent maximum rate
that banks presently may pay for deposits.
But two other things would logically be required:
1. A simultaneous increase in the 4 per cent
discount rate that member banks presently must pay on their
borrowings from the Federal Reserve, lest the widened disparity
impel these banks to converge on the Federal Reserve as the
cheapest possible source of funds.
2. A greater willingness to recognize that, if
banks find it more costly to obtain the funds needed to expand



their loan volume, they will either (a) charge more for new loans,
to recoup their higher costs, or (b) sh.ow less interest in meeting
new loan demand, since that would entail increased risk for a
smaller net return.
The disadvantage of the course outlined would,
quite obviously, be higher interest rates.

But there would be

these outweighing advantages:

- - Far from restricting the flow of funds to
meet mounting loan demands, the higher
rate structure would open, up a freer,
more effective flow of funds in response
to the most economically justified borrow
ing demands. The position of smaller
borrowers would clearly be improved.
- - With this freer, more effective flow of
funds that are already available in the
economy, economic growth, would be
made less dependent on a burgeoning
stream of newly created money and--in
consequence--made less vulnerable to
dangers of inflationary developments that
would end growth, and bring recession.
•- While these dangers can be debated--one
is always confronted by the statistics that
are not there--rising expectations, evi­
denced in financial markets and real
investment, and price warnings suggest
slightly higher interest rates would prove
beneficial to sustaining and stretching
out the expansion. And our present
balance of payments picture suggests the
further advantage of needed reinforcement^
of the voluntary program in the manne r

Federal Reserve Bank of St. Louis, One Federal Reserve Bank Plaza, St. Louis, MO 63102